(Not) Saved by Zero

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I’m sure you’re familiar with the irritatingly-effective Toyota commerical that used the song “Saved By Zero” by the Fixx to promote car sales with 0% financing. Well Bernanke could have busted out the boom box (or Toyota ad from YouTube) and blared the “saved by zero” hook over and over today with the Fed taking interest rates to somewhere between zero and 0.25% in a last-ditch effort to save the economy.

This is the scenario that we all envisioned when we were crying that the Fed is out of bullets. Well now, the Fed has essentially fired the last salvo of traditional expansionary monetary policy. It is officially out of traditional bullets. The question becomes two-fold: 1) will it work and 2) when you get to zero where do you go from there?

The answers are fairly simple because we have a fantastic case study from which to learn – the Bank of Japan.

Back in April of this year I penned a post called “Get ready for the new media buzzword: quantitative easing” which articulated the phenomenon that led to Japan’s lost decade. To reiterate the Bank of Japan, once interest rates had hit zero, tried quantitative easing with little success:

The BOJ initially switched from the usual approach to expansionary monetary policy?namely, a reduction in the target short-term interest rate?to quantitative easing because by that time it had been pursuing a target very close to zero (0.15%). The BOJ argued that, at an interest rate so close to zero, further nominal interest rate target reductions were constrained to be small, as under normal circumstances nominal interest rates are bounded at zero. As a result, the possible stimulus obtained through further reduction in the interest rate target was likely to be limited.

Under quantitative easing, the BOJ conducts open market operations aimed at increasing the money supply and reducing long-term interest rates. The recent intensification of the program has come in a number of forms. The increase in quantitative easing involves the BOJ engaging in open market transactions aimed at increasing its balance of current bank accounts held at the BOJ.

The problem with these liquidity measures is that we are not dealing with a liquidity crisis, we are dealing with a credit and solvency crisis. Adding more money to the system as credit cannot fix the underlying fundamental problems that are associated with insolvency due to the massive debt burden that many in this country (and the country itself mind you) are carrying.

So now with interest rates at zero and with the economy still on a nasty downward trajectory we’ll get to a point where the Fed, out of interest rate cuts will switch to quantitative easing, and as we can learn from our friends across the Pacific we will settle in to a nice pattern of no growth even with 0% interest. The question will be will it last for a decade like it did in Japan?

The markets may have rallied, but the economy will not be saved by this Fed and this interest rate cut or the next injection of cash. It will be saved only by eliminating the debt burden that is tied around the neck of everyone in the country. And you do that two ways: you either pay it off, or you go bankrupt.